Sunday, June 24, 2007

Echo ... Echo ... Echo

Is there an echo in here?
Meriwether's only nagging worry was that Long-Term hadn't been volatile enough. The fund had told investors to expect an accordion, with pockets of losses tucked between its bellows, but over the first two years, in only one month had Long-Term lost more than 1 percent. "Where's the accordion?" one investor wondered. To William F. Sharpe, a Nobel Prize-winning economist and an adviser to one of Long-Term's investors, the returns seemed surreally smooth. "We distinctly asked, 'What's the risk?'" Sharpe recalled. "Myron [Scholes] said, 'Well, our goal is to get the risk level [the volatility] of the S&P 500.' He said, 'We're having trouble getting it that big.'"1
* * *

The strategy paid off for a long time -- so well that in August 2006 Mr. Cioffi's team created a similar fund that would rely significantly more on borrowing to fund its investments to boost returns. At the time, the High-Grade fund had returned more than 36% in less than three years, according to documents reviewed by the Journal. By January 2007, it had gone through 40 months without a decline, and boasted a cumulative return of 50%.

The first quote, of course, is from Roger Lowenstein's book When Genius Failed, which chronicled the rise and fall of Long-Term Capital Management. The second quote is from a Page One article in The Wall Street Journal this weekend on the developing story of the potential collapse of Bear Stearns' two hedge funds connected to the subprime mortgage loan fiasco.

The parallels don't stop there. This from the September 1998 meeting held at the New York Federal Reserve among sixteen major Wall Street banks to discuss the rescue of LTCM:

James Cayne, the cigar-chomping chief executive of Bear Stearns, had been vowing that he would stop clearing Long-Term's trades—which would put it out of business—if the fund's available cash fell below $500 million. At the start of the year, that would have seemed remote, for Long-Term's capital had been $4.7 billion. But during the past five weeks, or since Russia's default, Long-Term had suffered numbing losses—day after day after day. Its capital was down to the minimum. Cayne didn't think it would survive another day.


[Merrill CEO] Komansky recognized that Cayne, the maverick Bear Stearns chief executive, would be a pivotal player. Bear, which cleared Long-Term's trades, knew the guts of the hedge fund better than any other firm. As the other bankers nervously shifted in their seats, Herbert Allison, Komansky's number two, asked Cayne where he stood.

Cayne stated his position clearly: Bear Stearns would not invest a nickel in Long-Term Capital.

For a moment the bankers, the cream of Wall Street, were silent. And then the room exploded.2

Fast forward to this past June 14th, when the creditors to Bear's two mortgage bond hedge funds met to discuss their deteriorating condition and what to do about it:

Many attendees were puzzled by Bear's apparent unwillingness to bail out the struggling fund, according to people who were there. After the meeting, these people say, there was sympathetic talk about Mr. Cioffi, a loyalist to the firm who seemed to be getting no help in return, and grumbling over memories of the Long-Term Capital Management crisis.

That afternoon Steve Black, J.P. Morgan's co-chief of investment banking, put in calls to Bear co-presidents and chief operating officers, Mr. Spector and Alan Schwartz. "Is Bear going to stand behind your asset-management company?" he asked Mr. Schwartz, according to people who were briefed on the conversation. Mr. Schwartz said he'd get back to Mr. Black.

An hour later, he called and said that on the advice of Bear's lawyers, the firm wasn't going to get involved, these people said.

Oh, Alan. Since when has Bear had to hide behind its lawyers to DK a trade? Just tell Steve to fuck off, like you normally do.

Since then, the continuing deterioration of the mortgage CDO market and inability of Wall Street banks to trade their way out from under their exposure to the Bear funds has pressured Bear to step up and bail out its progeny. More to the point, Bear has probably realized that letting these funds go completely down the toilet would piss off its bank counterparties and hedge fund clients so much that it could put a serious dent in its ability to continue minting money in the mortgage securities market, which has been a profit driver for the firm for years.

So, at last report, it looks like Cayne has knuckled under and agreed to lend up to $3.2 billion to its less leveraged fund to bail it out.

Too bad. Profit before principles, eh?

1 R. Lowenstein, "When Genius Failed: The Rise and Fall of Long-Term Capital Management," Random House, 2001, p. 77.
2 Ibid., pp. xx–xxi.
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